Keep Calm, Cross Your Fingers and Press On — monetary policy in today’s world

That might have been the thinking of the Federal Reserve when it surprised markets and chose not to start tapering back its quantitative easing policy. It had no choice given its mandate to target inflation low support the economy.  But its decision reminded TH about the reason why we have inflation targeting central banks in the first place.

Just like as a wee scotch is for an alcoholic, what seems to be a good idea right now is often inconsistent with our longer term interest.  In the case of central banks, it could be appealing to keep interest rates low today to help create jobs and growth and worry about the inflationary hangover tomorrow. To deal with exactly this problem, the New Zealand government revolutionised macro-economic policy making forever way back in 1991 when it was the first place in the world introduce inflation targeting – a system that ties the hands of the central bank by giving it strict mandate to keep inflation low and stable and operational independence to achieve that objective.  It was a huge success and during the years since many other governments followed suit.  But these days, it is hard not to ask whether the ultra easy monetary policy that one seems to see almost everywhere in the advanced economy world (including the US Federal Reserve decision to postpone tapering for a while longer)  is best.  Indeed, the nips might not being getting bigger, but the drinking (or liquidity) sessions are lasting longer and some are asking whether unintended consequences might be starting to reveal themselves.

The problem

More often than not, pursuit of the inflation objective is quite consistent with growth and job creation.  This is especially true when the economy is suffering from the effects of a recession.  In that case, the excess economic capacity (i.e. weak growth and unemployment) puts downward pressure on prices and creates the potential for disinflation (falling inflation) or even deflation.  To combat this, the central bank will ease monetary policy, encouraging firms and people to borrow and spend; hopefully on productive investments and job creation. This is the situation advanced economies have been in for over  5 years now.

Generally speaking central banks have achieved their goals pretty well. The problem is that given that they have a mandate and a reputation to “do whatever it takes”, other branches of government may felt that they have had some scope to slacken off a bit.  This wouldn’t be a worry if using loose monetary policy to stimulate the economy was costless.  The truth though is that loose monetary probably does have some costs.  For example, if interest rates are too low for too long, it could create a bit of a housing bubble (and you will recall that it was the bursting of US and UK housing bubbles that was one of the factors behind the severity of the global financial crisis in 2008).

Here is a picture that illustrates the problems.    The illustration shows the “marginal benefits” and “marginal costs” from loosening monetary policy.  Each time the central bank adopts a looser monetary policy there is an extra cost (the marginal cost) of doing so shown by the height of the marginal cost curve. It slopes upwards because central banks choose the most effective way of loosening policy first, before moving to more unconventional and potentially costly means.  The cumulative, or “total”, cost of all the central banks actions (each quarter of a percent interest rate cut, each $100million in asset purchases etc.) is shown by the area under the curve.  Similarly the extra benefits of loosening monetary policy are shown by the height of the marginal benefits curve and the total benefit is shown by the area under that curve.

costs and benefits of monetary policy

The curves labelled MB* and MC* are the curves that reflect the costs and benefits when all policy makers (central banks, treasuries, and financial sector policy makers) make the best decisions to keep the economy fully employed and growing while maintaining low and stable inflation in the longer term.   If the central bank is doing its job to the best of its ability, it will loosen policy until the marginal benefits of extra loosening just equal the marginal costs of that loosening.  When you do that, the  total net benefits will be as big as they can possibly be and the central bank, along with all the other branches of policy, will have done as well as they possibly can.

When other macropolicy makers slacken off, however, the benefits of using monetary policy increase so that central bankers keep interest rates lower for longer or engage in more quantitative easing. The result of excessive reliance is a higher total cost from monetary policy.  This is shown by the blue area.

The problem for those evaluating the cost and benefits of monetary policy is that central banks always seem to  do what is “optimal” – equating marginal benefits with marginal costs so that the costs of monetary policy action will never seem to outweigh the benefits.  What they should really do is a counterfactual calculation which assumes that other macropolicy branches of government (the Treasury, financial regulators, etc.) are fulfilling their responsibilities and rather than relying on their central banks.  The problem is that this is almost impossible to do.  As a result, we will never really know whether monetary policy is excessive.  But given the state of the fiscal debate in the United States and efforts to deal with financial fragmentation in Europe, TH has some concerns — perhaps time inconsistency in monetary policy has given way to moral hazard in other policy areas.



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